The Impact of Regional Trade Agreements on Excluded Countries: Trade Diversion and Harm, Study notes of Latin

Download The Impact of Regional Trade Agreements on Excluded Countries: Trade Diversion and Harm and more Study notes Latin in PDF only on Docsity! 187 CHAPTER 8. TRADE BLOCS AND THE REST OF THE WORLD Introduction RIAs are, by nature, exclusive clubs. Every country in the world is excluded from nearly every RIA in the world, and every RIA excludes nearly every country. This discrimination against excluded countries is alive and well and causes significant trade diversion – of which we present new empirical evidence – and trade diversion can harm excluded countries (in shorthand, the rest of the world), particularly for large blocs. The extent of that harm depends on how much the RIA diverts trade, and on the structure of the rest of the world’s economy in the sectors in which trading patterns are changed. As a rule, trade blocs harm non-members least if they are less trade diverting, liberalize their external trade, and boost global competition by increasing member efficiency and growth. The other major issue in the intersection between RIA’s and the rest of the world is whether or not RIAs are stepping stones toward globally freer trade, or millstones around the neck of progress toward that goal. Many arguments have been advanced for the benign view – e.g. that regionalism stimulates global trade negotiations, that it makes negotiations simpler, that ‘open-regionalism’ liberalises trade, or that blocs can advance further and faster than global negotiations. However, in truth, the world of many trade blocs is still too new to allow a definitive answer to this question, and much of the evidence shows that advances in multilateral trade negotiations have led – not followed – the formation of trade blocs. Moreover, there are also strong analytical reasons to suggest that regionalism is more likely to undermine than support full free trade, and may increase the chances of trade wars. Finally, this chapter briefly considers the WTO’s rules and practices on regionalism. Its rules provide some discipline on the worst kind of trade blocs, but cannot, in the end, prevent members from creating RIAs that harm themselves or others. Moreover, the rules do not fully apply to developing countries and are not enforced very actively anyway. We can not identify rules changes that are both feasible and desirable, but we do urge that current rules be clarified and enforced. We also suggest that more attention be paid to assessing the economic effects rather than just the legal standing of proposed RIAs. 8.1 Trade discrimination is still significant Trade discrimination against excluded countries commonly causes significant trade diversion. While this diversion is not inevitably harmful to the rest of the world, it will be under two common circumstances: when non-members tax their international trade (e.g., by imposing tariffs), and when their export prices fall as a result of falling demand. Merely examining the value of the rest of the world’s exports to the RIA is not sufficient to identify harm. One really needs to consider the rest of the world’s imports and the prices paid for them in terms of exports – the terms of trade. Finally, one must examine the difference between the value of a unit of exports and the resources required to produce it. 188 One might think that after five decades of tariff cuts and two of non-tariff barrier reforms, trade restrictions are so low that they hardly matter. While tariffs of 30% are less distortionary than tariffs of 60%, trade barriers are still high enough to impart a significant bias to international trade. Preferential reductions in these tariffs—RIAs—will further distort trade and probably impose costs; even a discriminatory tariff of 5% can have significant effects on import sourcing if goods are highly substitutable. If discrimination extends to areas such as standards testing and enforcement, or public procurement, trade diversion is likely to be even more significant. The degree of discrimination arising from an RIA is related to the height of the “normal,” non-preferential, trade barrier – the “most-favored nation” (MFN) barrier – and the proportion of trading partners or trade covered by MFN status.1 Only about 14% of EU members’ imports pay tariffs.2 These imports, which are clearly discriminated against, include some goods from developing countries outside the ACP grouping and non-European industrial countries. Even for manufacturers, the least restricted sector, tariffs range up to 22% for motor vehicles, 18.2% for footwear and 13.4% for clothing. Tariff peaks facing non-preferred exporters are even higher in the United States (up to 25% for motor vehicles, 57% for footwear and 35.3% for apparel), and Japan (10.2%, 48.8%, and 17.8% for the same goods). Developing country tariffs also remain high enough to distort the tradeoff between home and imported supplies – and between preferred and non-preferred sources of imports. Table 8.1 presents averages and maxima for a series of developing countries and the common external tariffs of some current or planned customs unions. They show significant discrimination against suppliers who do not receive exemptions. 1 The term “most favoured nation” arises from the long-standing trade diplomacy practice of guaranteeing a partner treatment at least as good as is granted to the most favoured partner. If this extends to all partners, all are treated equally in a non-discriminatory fashion. Universal MFN is the cornerstone of the GATT, the treaty governing trade relations since 1947. But the term “most favored” is now ironic. Almost no country pays tariffs above MFN levels (only North Korea in the EU), and most pay less via the General System of Preferences (GSP), other unilateral preferences, or formal RIAs: only ten countries pay MFN tariffs on all their exports to the EU. All others, except North Korea, receive some sort of preference (Winters 2000). 2 After allowing for imports from members, RIA partners, trade under the GSP, and goods with zero MFN tariffs. This is about 40% of the EU’s imports from non-EU sources (Sapir, 1998). 191 in the relative prices of the rest of the world’s exports and imports – its terms of trade – that matters, not the loss of exports per se, and it is this that should be the focus of investigation.3 Third, if the loss of exports is non-marginal, some of the benefits of specialization itself will be lost. 8.2.3 Exports might be worth more than they cost If a unit of exports generates more welfare than would alternative uses of the resources taken to produce it, losing exports is costly. For each unit of exports lost, real income will fall by the difference in the value of the exports – the imports that they buy – and their value in the domestic economy.4 This will happen if exporting generates super- normal profits because export markets are imperfectly competitive. Those profits will be lost on any trade that is diverted and cannot be replaced by alternative sales at the same price. Industries with economies of scale are in a similar position. If the creation of an RIA causes industry in the rest of the world to lose scale economies, the cost of all its output increases, imposing costs on other consumers of its output, and reducing its profit margins. This is the story behind predictions (e.g. by Haaland and Norman, 1992) that EFTA would lose significantly from the EU’s Single Market Programme. A major potential wedge between the value and the cost of exports is export taxes. Under perfect competition, the price of a unit of exports equals the returns to the factors used in producing it (including entrepreneurship) plus any taxes imposed. If the export is lost – and not replaced – only the former is recouped. Explicit export taxes are relatively rare these days,5 but implicit taxes abound. Most importantly, import taxes (tariffs) actually tax exports.6 If an RIA cuts an excluded country’s total exports this eventually implies a cut in imports. If these imports are worth more than they cost, because they pay taxes, welfare is lost as they fall. Similar arguments apply to other implicit export taxes, such as excise taxes on inputs, excessive fees for international communications services, or an overvalued currency. With average tariffs exceeding 10% in most developing countries, real income losses equivalent to over 10% of the value of the diverted trade will be common. Trade diversion can also cause losses if exports generate positive externalities. Most relevant, probably, are exports of manufactures, which many observers believe have spill-over effects through training managers and workers, increasing marketing experience and reputation within markets, or improving 3 It is also possible that by improving efficiency or generating economies of scale, the RIA will drive down the prices of its exports – the rest of the world’s imports. Then, the rest of the world benefits from the RIA, as Gasiorek, Smith and Venables (1992) predicted for the EU’s Single Market Program and Flores (1997) for Mercosur. 4 This, of course, refers to total exports – if exports diverted from the RIA can be sold elsewhere at the same price, no damage is done. 5 Besides, one feels uneasy criticizing an RIA because it reduces an exporter’s ability to levy taxes on members’ imports. 6 Import taxes allow domestic producers to raise their prices and, thus, to bid resources away from exporters. Alternatively, think of trade as the process of swapping exports for imports: if the government requires 10% of the imports to be turned over to it as tax, the effect is the same as if it requires 10% of the exports to be turned over. Trade is discouraged and both exports and imports fall. 192 technological know-how in general. The evidence in favor of such externalities is mixed, (Aitken and Harrison, 1994), but if they do exist exports are worth more than the revenue they generate, and their loss is correspondingly socially harmful. A related argument views production and employment as valuable in themselves, and holds that trade diversion reduces them. To be true, this requires both that the diverted exports cannot be replaced by other exports and that the resources released as total exports fall cannot be re-employed. Under these circumstances trade diversion causes losses, but one really needs to know why the resources cannot be employed elsewhere. Setting aside transitional unemployment as workers seek new jobs, which is real enough but limited in duration, it is not clear why aggregate employment depends on the level of exports. And if it does, is the problem the RIA’s trade diversion – or the rest of the world’s labor market rigidities? 8.2.4 Large RIAs worsen non-members’ terms of traders Large RIAs have an additional effect. The effect of an RIA on the prices at which the rest of the world’s firms can sell their products depends largely on its size. Small RIAs will rarely matter, as they almost never affect the prices at which trade occurs. But some RIAs – the EU or, potentially, the FTAA – are large enough to affect world prices. Their behavior has implications for everyone in the market – positive for buyers if the price falls, and negative for sellers – whether or not they deal with the RIA itself. The significance of price changes is that they affect not only marginal trade, but the whole volume of existing trade (Chapter 2). If a shock means that exporters have to drop their prices to sell the last 1% of exports to member countries, this is a small misfortune if it is only that 1% that carries the lower price. But if they cannot discriminate between buyers, they have to drop the price on all sales – a pure loss on the first 99%. It is more common, perhaps, for goods to be differentiated by place of production, and for different markets to be segmented. Here exporters face downward- sloping demand curves in each of their markets: they have to reduce prices to sell more units. Lower demand from the RIA market puts downward pressure on the prices of their sales in the RIA; this leads to a combination of exports being reoriented to other markets and resources switched to producing other goods. If the RIA takes a large proportion of the output of the affected goods, and if the goods account for a large share of total output, the price reductions could be significant for rest of the world suppliers: greatest on their sales in the RIA, next in other markets for the affected exports, but present in markets for all other goods. Whichever of these applies, factors of production in the exporting country earn less – their income falls. Despite being central to the theoretical literature for over a century, the terms of trade effects of commercial policies have been almost entirely neglected by empirical economists. It has been identified by CGE modellers - for example, Gasiorek, Smith and Venables (1992) and Scollay and Gilbert (2001). The latter model many of the putative RIAs in the Asia-Pacific region and find that non-members typically lose - see table 8.2. 193 Turning to genuine empirical work exploring actual outcomes, among twentieth century publications, we cannot identify even a single empirical ex-post study of regional integration that focuses on price effects.7 Recent research in the World Bank has started to fill this lacuna. First, an example of “large market” effects with small export volumes is sales of live cattle in South America (Gupta and Schiff, 1997). Cattle are not easily transported within developing countries and are subject to rigorous veterinary regulations in most developed countries. Hence Latin America represents a natural regional market. In 1966- 68, prior to the 1969 formation of the Andean Pact, Peru imported mainly from Argentina but also from Colombia (Table 8.3) and accounted for about 30% of Argentine cattle exports. By 1970, the situation was reversed with the member supplier, Colombia, displacing the non-member. 7 The common approach to measuring the effects of RIAs on non-members, is to consider changes in the rest of the world’s exports, which, as we have argued above, is, at best, an indirect approach to the rest of the world’s welfare. Table 8.3 Peru’s Cattle Imports and the Andean Pact 1966-68 “Before” 1970-72 “After” Imports from (000 metric tons) Argentina Colombia 32 7 1 27 Total Imports # # Premium on exports to Peru (%) Argentina Colombia 7 -3 4 2 Table 8.2 Estimates of Possible Welfare Effects of Certain Asia-Pacific FTAs (% of real GDP) RIA Welfare effect for members Welfare effect for non- members Welfare effect for World FTAA 0.08 - 0.02 0.01 APEC Preferences 0.58 - 0.12 0.27 Japan - Korea - China 0.50 - 0.03 0.09 Japan - Chile - 0.03 0.00 - 0.01 Japan - Canada - 0.02 - 0.01 - 0.01 AFTA - CER 0.44 - 0.01 0.00 Source: Scollay and Gilbert (2001) 196 Box 8.1 Trade Diversion and Investment Switching In the late 1980s, the five continental EFTA countries were very heavily dependent on the EU (then called the EC) market. On average, they exported 35% of GDP and 53% of their exports went to the EC – roughly 18% of income was generated directly from sales to the EC. The EC’s Single Market Programme was designed to integrate EC markets and, through increasing competition and exploiting economies of scale, raise the efficiency of EC producers (see sections 2.5 and 2.6 above). This was a direct threat to EFTA producers, especially in the sectors likely to be most affected – where the EC market was most fragmented and imperfectly competitive and thus had the most room for improvement. These were the skill-intensive engineering sectors which, because they were also imperfectly competitive in EFTA, were the sectors generating the largest labor rents and profits in EFTA members. Estimates – probably rather conservative – suggested that EFTA output in some of these sectors would fall by over 5% and GNP by nearly 0.5% as the SMP proceeded (Haaland and Norman, 1992). Shifts in investment around this time made these predictions look only too plausible. More or less as the SMP was announced every EFTA country suffered a decline in FDI inflows and an increase in outflows. These changes reversed themselves only as the European Economic Area (EEA) or full accession to the EC was embraced (Baldwin, Farslid and Haaland, 1996). Although analysts reckoned that many excluded countries would benefit from the SMP as EC demand for their exports increased and EC export prices fell (Gasiorek, Smith and Venables, 1992), in EFTA these benefits were swamped by production losses just noted. The solution for the EFTA countries was to join the SMP and benefit themselves from the large, more efficient market. This was predicted to turn the GDP loss of 0.5 % into a gain of nearly 3%. As this is what they did, through the EEA (and eventual full accession), we never observed the costs of their being excluded. However, both the fact that they did so and the observed switches in investment flows suggest that the threats were perceived to be serious (Haaland and Norman 1992). One of the main fears of excluded countries is that a newly formed or deepened RIA will absorb investment that they might otherwise receive. Regional integration frequently leads to temporary investment booms within an RIA; if there is a finite set of investment opportunities or a finite volume of investable funds, it is not unreasonable to fear some switching between recipients. We have not, however, found hard evidence that investment or FDI inflows have fallen in excluded countries as a result of RIA creation. EC-92 and EFTA provide probably the strongest test of losses due to investment switching. The expected shock was large, and given that investment is forward looking, actual investment is likely to respond to these expectations. FDI fell in every EFTA country after the SMP was announced, and recovered only as these countries signed into the EEA or committed to accession to the EU (Baldwin, Forslid and Haaland, 1996). Unfortunately, however, while the cited study is suggestive, it offered no formal ex-post analysis of the situation, and so it is possible that this reflected cyclical factors rather than a structural effect. 197 8.3 The Road to Multilateralism: Are RIAs Stepping stones or Mill-stones? This section switches the focus from the immediate consequences of regionalism for non-member welfare to whether it sets up forces that encourage or discourage evolution toward globally freer trade. Given the difficulties in understanding the dynamics of any reform, it is hardly surprising that there are no categorical answers yet. Chapter 3 showed that RIAs can be set up in ways that promote liberalism internally. The systemic aspects considered here, however, are less optimistically balanced. Most of the plausible systemic arguments suggest that regionalism will tend to undermine multilateralism. Even those that do not, tend to suggest that, even if regionalism helps to reduce levels of protection, it does so in ways that increase the chances of fragmenting the world economy into warring blocs. The stakes in the bet as to whether RIAs are stepping stones to multilateral trade liberalization or millstones around its neck are truly huge.8 Opening trade and increasing competition have been part of virtually every sustained economic growth experience, and the unprecedented post-war growth of world output and income have clearly been allied to these factors. Moreover, systemic effects affect everybody, even bystanders. This is particularly important for small and medium-sized economies, which depend heavily on international trade and are the principal beneficiaries of an orderly and non- discriminatory trading regime. While economists have built many theoretical models of RIAs and the world trading system, few have generated testable predictions about observable phenomena, still less, measurable ones. Moreover, even if we had testable predictions, we have very little to test them on. Few RIAs have been sufficiently effective and long-lived to allow us to draw empirical conclusions, and a world of “many” RIAs is a recent phenomenon. This has two implications. First, although we need to make all the use of empirical information that we can, ultimately, we have to rely quite heavily on a priori reasoning. Second, the question about regionalism and multilateral trade concerns the future, not the past. The four decades to 1986 saw remarkable progress in liberalizing trade in industrial goods multilaterally, but there was little effective regionalism. The last decade and a half has seen, in addition to continuing progress on industrial goods, a start made on agriculture and services and a huge reversal in developing country rhetoric about and practice of trade policy. This has been accompanied by a growth of regionalism, but, at least in a temporal sense, could not have been caused by it.9 The question for this section 8 Loosely, multilateral trade liberalization means nearly all countries reducing barriers on imports from nearly all partners. 9 Some theorists have argued, albeit in very particular models, that regionalism has sprung from the success of multilateralism. For example, Ethier (1998a,b) assumes that as the world economy liberalizes the incentive for any individual developing country to do so increases. He sees RIAs as the preferred modality for this liberalization because compared to non-discriminatory opening they appear to allow greater confidence that FDI inflows will follow reform. Freund (##) argues that as MFN tariffs come down, RIAs become easier to sustain (in a sense defined below) and trade diversion becomes less costly relative to the benefits of increased competition. 198 is precisely what this burst of regionalism (and any continuation of it) implies for future multilateral trade liberalization.10 Regionalism affects the progress of multilateral trade liberalization through a mixture of changing the internal incentives for trade liberalization, affecting the way in which RIA members interact, and changing the interactions between RIAs and the rest of the world. Chapter 3 dealt with the first two, noting, inter alia, the danger that producer lobbies can drive RIAs toward trade diversion and the beneficial dynamic that trade- creating RIAs might have in reducing protection. This section considers the interactions between members and non-members, including discussions of “domino regionalism,” multilateral trade negotiations, and “open regionalism.” Three types of argument are made. First, the behavior of the major blocs – the EU, NAFTA, APEC – will affect the multilateral system in ways that are basically exogenous for developing countries. All that the latter can do is to try to seek to influence that behavior – perhaps via international institutions – and prepare for its consequences. Second, RIAs (including their own) may affect the behavior of developing countries themselves, altering their own propensities for non-discriminatory liberalization and their willingness to support and protect the multilateral system. If enough developing countries are affected, this too will have systemic effects, in which case developing countries must themselves take some direct responsibility for the consequences of regionalism. Third, regionalism could also affect the processes of multilateralism as well as the outcomes (see Subsection 8.3.2). It might seem that asking whether regionalism could reverse multilateral trade liberalization is merely an intellectual indulgence. After all, do not the WTO rules governing RIAs expressly forbid them to increase in trade barriers? For several reasons, this view is too simplistic. For many developing countries there is a wide gulf between their actual (applied) tariffs and the maxima committed to in their formal bindings in the WTO. For example, when Mexico nearly doubled tariffs on 503 import items from non-NAFTA sources in 1995, it did so without violating any bindings. WTO rules are ambiguous and poorly enforced. A determined government can make trade policy more restrictive in ways more or less immune to WTO disciplines—say, through anti-dumping actions or health regulations. In a world edging toward general trade liberalization, any deceleration in that process is equivalent to an increase in protection relative to the original path. Box 8.2 Stepping stones or Mill-stones? – A Summary At first blush, regionalism looks like an important step on the road to global free trade. The recent explosion in RIAs (see, for example, Figure 1.1 on page ## above) has, after all, gone hand in hand with the greatest multilateral trade liberalization in history. But despite the large number of RIAs in the world, most are too recent, too incomplete, or too idiosyncratic to provide conclusions about a world of many RIAs, and there is little empirical evidence about the effects of regionalism on the world trading system. 10 On a broad historical canvas, of course, regionalism – which goes back to at least 1815 – pre-dates multilateralism. But the current trading system based on the GATT arose in 1947 from other forces and pre- dated significant regional arrangements between independent powers by at least a few years. 201 arising from breaking it. Breaking it would entail choosing a policy that maximizes immediate welfare followed by a period of punishment. This tradeoff depends on three sets of factors: first, the rate at which the future is discounted, because cheating (raising your tariff) entails higher immediate payoffs followed by lower payoffs during the punishment phase. The higher the rate of discount – the lower the relative weight placed on the future – the more likely a country is to cheat. Second, the probabilities that cheating will be punished (and how and for how long) and that cooperation will be rewarded (that the other party will not cheat, and the agreement will not be overturned by some exogenous shock). And, third, trading arrangements, such as RIAs, which affect the volumes and patterns of trade. The lower the tariff in a trade agreement, the greater the (immediate) benefits of cheating (raising your own tariffs unilaterally), and thus the stronger (more costly) the punishment needed to make it sustainable. That is, stronger punishment allows more cooperative behavior, i.e., lower tariffs in the agreement. This framework allows us to ask directly and simply whether, by changing the various incentives, regionalism fosters lower or higher tariffs on the rest of the world. Bond and Syropoulos (1996) suggest that, starting from world-wide free trade, introducing RIAs and then allowing them to expand creates two countervailing forces: the incentive to cheat grows, but so too does the welfare loss in the resulting trade war. In their model, the former dominates, with the result that it is more difficult to maintain free trade in a bloc-ridden world, and that the minimum tariff that can be supported by this kind of cooperation increases as bloc size increases. In short, regionalism increases the pressures for protectionism. The discount rate is crucial in the operation of these so-called trigger strategies because it trades off the immediate benefits of cheating against the eventual costs of trade war. This raises the question of the time scale over which these games are played. In terms of individual tariffs and tariff wars, the period required for retaliation is so short that there are hardly any gains to cheating. Thus, discipline seems virtually complete and the model suggests that nothing much affects the cooperative outcome. It is, however, more plausible to view regimes as the instruments, the GATT rounds as the natural periodicity, and policies (such as the zeal with which anti-dumping policies are applied and the use of health and technical regulations) as the weapons. Then the periods required to recognize defection and retaliate become much longer. The important effect of regionalism is not on the “tactics” of trade policy, but on the “strategy.” RIAs will tend to reduce the incentive to take a world view of the broad trends of trade policy because intra-bloc trade is seen as a substitute for trade with the rest of the world. The danger is that countries in RIAs will be less willing to sustain liberal regimes. Box 8.3, which explores the issue empirically, suggests that regionalism is accompanied by neither an immediate retreat into – nor retreat from – protectionism, but rather that multilateral liberalization has tended to lead regional liberalization. Bond, Syropoulos and Winters (2001) use a similar framework to consider the deepening of an existing regional arrangement. They observe that, as the bloc deepens, its 202 trade with the rest of the world tends to decline. The excluded countries then find the original agreement unattractive, and will initiate tariff increases unless the bloc Box 8.3 Regionalism and Protection Theory cannot determine whether RIAs will increase their protection against non-members. This box discusses one attempt to settle the matter by direct empirical observation of the behavior of blocs (Foroutan, 1998). While most empirical work necessarily considers particular case studies, this study takes a cross-developing- country approach. As noted previously, nearly every country is in or is discussing an RIA, which makes it difficult to devise a comparator group for members of RIAs. Foroutan first exploits the fact that in the past not every country was a member, and, second, classifies RIAs according to whether they were “effective,” which she defines as having a material effect on the share of intra-bloc trade in the group’s total trade. Comparing members of effective and ineffective blocs sheds some light on the consequences of RIAs for external trade policy. The attribution is necessarily rough and ready, but effective RIAs among developing countries (up to 1995) are defined as including: CACM (1960-75; and since 1990); Andean Pact (since 1990), Mercosur, UEMOA and SACU, while individual countries affected by their RIA memberships include: Mexico, Israel, Zimbabwe, Kenya and Cameroon. Foroutan then compares these developing countries with those that were not in effective RIAs across three dimensions. (The samples differ across the three exercises below because of data availability.) Average applied tariffs and NTB coverage. The Latin American RIAs now have among the lowest average tariffs and NTB coverage among developing countries and have achieved the greatest liberalization since the mid-1980s. Except for Chile, the small “non-RIA” group has made much less progress. Until 1994 neither RIA nor non- RIA countries in Africa had displayed much tariff liberalization (NTB data are not available) and using latest available data the mean average tariff is almost the same between the two groups. South Asia has liberalized but remains highly protected, East Asia has always been relatively liberal but now has higher average tariffs than reforming Latin America, and MENA shows no reform and fairly high average protection. The most liberal group in the table is the members of North-South RIAs – Israel, Mexico, and Turkey. Uruguay Round Concessions. Here the only feasible comparison is between the Latin America “RIA” group and all non-RIA countries. The former group cut its bound tariff by more and bound more of its tariffs in the Round than did the latter, but it also completed the Round with significantly higher bound tariffs. Openness. Treating (non-fuel imports + exports)/GDP as a measure of openness finds the “non-RIA” group displaying the greatest average increases between 1980-84 and 1990-94 (see table). The Latin America “RIA” countries show some increase, but still not to the levels achieved in the 1970s. 203 Strong trade reform appears to be mostly associated with RIA membership. Can we conclude, therefore, that it is caused by RIA membership? For five reasons we probably should not do so yet. First, a more detailed history shows that much of the trade reform precedes RIA membership: e.g., in Mexico, Argentina, Brazil, and Turkey. Second, at a detailed level, plenty of RIA countries have not reformed (CACM in its early period, Africa) and plenty of non-RIA countries have (Chile, Korea, Indonesia). Thus, general tendencies notwithstanding, there is clearly much more to reform than RIA membership. Third, many of our hypotheses about the effects of RIAs on protection operate only over fairly long time periods, whereas our data cover mostly rather recent integration. Fourth, the general results depend very heavily on Latin America experience. If we believe that other forces were at work in that region, we must be cautious about attributing too much to regionalism. Fifth, the results on actual openness tend in the opposite direction from those on policies. On the other hand, Foroutan’s results certainly refute the simple hypothesis that RIAs necessarily and immediately lead to protectionism and are consistent with the idea that regionalism helps to lock-in previous MFN liberalization. As with so much of this debate, the jury is not so much “still out,” but “still listening” as sufficient evidence accumulates waiting for time to provide enough evidence to resolve the issue. Better than waiting, however, would be for RIAs to arrange their policies and institutions to ensure that they actually deliver their liberal promise rather than the opposite. Source: Foroutan (1998) (Box 8.3, contd.) Average Tariffs in RIA Members and Other Countries (a) Average Tariffs (%) Openness (%) (b) “RIA” Countries “non-RIA” Countries “RIA” Countries “non-RIA” Countries 1981-85 1990-94 1981-85 1990-94 1980-84 1990-94 1980-84 1990-94 Countries in North-South RIAs 20.6 10.2 19 22 Latin America 31.0 13.8 25.8 15.4 26 30 174 107 Africa 35.6 31.0 30.7 24.4 47 45 40 48 South Asia 59.9 41.8 22 30 East Asia 20.5 15.0 43 68 Middle East/ North Africa 26.3 26.6 40 43 (a): (b): 206 parallel would be that if there is gang warfare in your neighborhood, it may be best to belong to a gang. That does not make gangs a good thing. A further problem with the view that domino effects necessarily render regionalism benign is that it takes two to tango. Even if excluded countries seek access to an RIA, the existing members may not wish to let them in, at least not without significant down payments (see, for example, Andriamananjara and Schiff, 2001). RIAs tend to turn the terms of trade against non-members, so the optimal bloc size – looking from the inside – is less than the whole world: there needs to be somebody outside to exploit. Even voluntary regionalism can make everyone worse off. A simple illustrative model of these sorts of effects is shown in Figure 8.4. Frankel (1997) divides a world of many countries up into four continents, with zero trading costs between countries within the same continent and positive costs between continents. Start with each continent practicing MFN trade policy. Any one continent could then improve its welfare by forming an FTA: overseas producers would have to their lower prices to mitigate their loss of competitiveness, and would, as a result, suffer either a decline in income or the loss of part of the FTA market. From here a second continent benefits by creating an RIA, switching a loss of welfare into gain, and thence the third, converting larger losses into smaller ones. Even the fourth gains by creating an RIA, although by then all continents are worse off than under MFN policies. World welfare falls at every stage, but no continent has the incentive to undo the regionalism individually. 13 Could such processes lead all the way to global free trade? Almost certainly not; again because insiders benefit by turning the terms of trade against outsiders and so seek to prevent unlimited expansion of their blocs. If several roughly equally sized blocs formed, it is possible (not guaranteed) that they would subsequently negotiate with each other to achieve global free trade. However, in most models it is more likely that multiple blocs will be of different sizes and that the final steps to free trade will be vetoed by the 13 Frankel’s model is not at all robust for small asymmetries in size or changes in parameter values can change the results. However, it is sufficient to demonstrate formally the interaction between RIAs. Figure 8.4 Domino Regionalism -4 -3 -2 -1 0 1 2 3 0 1 2 3 4 Number of Blocs W el fa re re la tiv e to n on - di sc rim in at io n Inside Outside World 207 larger bloc(s). (Nordstrom (1995) and Campa and Sorenson, 1996). Only if RIAs were somehow obliged to accept any country that wished to join is evolution to global free trade likely, and even then in the course of achieving it, countries may suffer lower welfare than they had under MFN tariffs. Thus the speed and security of the convergence to global free trade would be critical considerations in advocating such “open access” even if it were feasible, which it is not (Box 8.4). Insider resistance to expansion certainly occurs in the real world, although probably less for consciously exploitative reasons than from a general resistance to change and a fear of budgetary consequences. Consider, for example, how long it took the EU to even admit the possibility of Turkish accession, or how tortuous the process of accession has become for the countries of Central and Eastern Europe. Similarly NAFTA has rejected overtures from many countries, and APEC had a moratorium on accession from 1993 to 1996. Box 8.4 Is Open Access the Key to Benign Regionalism? It has been suggested both in theoretical models (e.g. Yi, 1996) and policy discussion (e.g., Bhagwati, 1991, Serra, 1997, but dating back at least to Preparatory Meetings for the London Monetary and Economic Conference of 1933), that the key to ensuring that RIAs are stepping stones to multilateralism is “open access:” that any country willing to abide by an RIA’s rules should be guaranteed admission. To date no RIA has offered such unconditional access: most have restricted geographical domains, and even within these domains it is existing members who determine whether applicants meet the conditions. A simple rule of, say, internal free trade or “national treatment for investors” may be objectively assessable, although even then the transition period needs to be negotiated, but anything more – e.g., dispute settlement, excluded sectors or common anti-dumping policy – certainly requires negotiation and hence threatens candidates with delay and veto. Where an RIA involves few conditions – e.g., the Cross-Border Initiative in East and Southern Africa, in which neither internal preferences nor external tariff harmonization are rigorously enforced – there is little incentive to exclude geographically eligible countries. Indeed, there is perhaps some incentive to include them in the attempt to enhance negotiating power in world trade talks and vis-a-vis international institutions. The result is expansion to include a wide range of different economies. NAFTA, where the principal rules are completely free trade in goods and open investment, might, on that account, have automatic entry, but it doesn't. Accession is not restricted geographically but is “subject to terms and conditions as may be agreed....” This resistance is probably aimed more at avoiding adjustment in the USA, however, than because other issues such as quotas for professional migration or dispute settlement require negotiation. The EU stands ready to sign Association Agreements with many neighboring countries and with all of the middle-income members of the Africa, Caribbean and Pacific countries – but only on its own terms covering issues such as rules of origin, excluded sectors, the use of anti-dumping duties etc. Mercosur is happy to accept new members, but, given that fairly deep integration is planned, detailed negotiation is required. Association – Chile’s status – is easier, but does not offer full integration and still required several years of talks. 208 Full membership in the EU is anything but “open access.” The UK had to ask three times, it will take Turkey at least 30 years to get in, and there is no timetable for countries like Ukraine or Georgia. Negotiations are tortuous once accession is agreed in principle. The EU’s “White Paper” on Eastern European Accession was ____ pages long and each of the six first wave candidates faces a formidable list of demands and requirements prior to membership. In several cases they are required to adopt policies from which some existing members are exempt – for example, the Social Chapter of the Maastricht Treaty. In all the cases listed here accession may be better for non-members than suffering discrimination on the outside, but it may not be better than MFN trade. Thus, since the expansion of RIAs all the way to global free trade is far from assured, one cannot necessarily view successful accessions as stepping stones to multilateralism. Moreover, negotiated accession can lead to asymmetric agreements in which benefits to developing country candidates are reduced and possibly appropriated by existing members via side conditions on issues such as the environment, labor regulations, rules of origin, etc. As the more complex aspects of RIAs – especially those with budgetary implications – have to be negotiated, access can never be automatic and unconditional. Hence it seems rather naive to believe that in practice the WTO could write or enforce general rules for open access. While relatively open access – e.g., APEC, which has created a slogan of “Open Regionalism” – might seem less threatening and exploitative than closed access – e.g. NAFTA – one cannot rely on this route to deliver benign regionalism.14 Most formal analysis of domino regionalism assumes equally sized countries identical in every respect except for the good in which they have comparative advantage. Thus the only significant characteristic of an RIA is its size, rather than which countries comprise it, and there is no issue about how to share the benefits of integration. Once we break free of this assumption, the compatibility of different partners and struggles over distribution start to matter – and greatly complicate the process and analysis of RIA enlargement Given the different interests of excluded and member countries, what does the evidence show about the domino effect? The first column of Table 8.4, denoted “Strong,” lists nine RIAs that have expanded over time while maintaining the nature of the RIA or strengthening it. Among these are the EU, APEC, the expansion of CUSFTA to NAFTA, and others in Sub-Saharan Africa, Asia, Central and Eastern Europe, and the Caribbean. The second column is denoted “Intermediate” because the expansion is through a weaker form of integration. It shows the EU and MERCOSUR, two customs unions, expanding by forming FTAs, with Mediterranean and Central European countries for the EU, and with Chile and Bolivia for MERCOSUR. Note that MERCOSUR differs from other RIAs in the sense that its members wanted to expand by accepting Chile as a member but Chile 14 In November 2001 Jim Sutton, Trade Negotiations Minister of New Zealand, one of the champions of ‘Open Regionalism’ stated that it was inconceivable that any bloc would grant totally automatic rights of entry to countries willing to abide by its rules - Fourteenth Pacific Economic Co-operation Council, Hong Kong, 28-30 November 2001. 211 current world. Such problems do not look very serious at present, for developed countries have many other non-exploitative relationships with developing countries and may not find ‘insurance premia’ worth pursuing in this way. However, insurance is about ‘worst case’ scenarios, and our point is that developing countries should not complacently assume that regionalism will preserve them if a crisis arises. Moreover, one might observe the same sort of phenomena in today’s world, albeit in a much attenuated form. One the reasons that Prime Minister Helen Clark cited for New Zealand seeking a regional arrangement with Singapore was a fear of being left outside as the world split up into blocs in none of which New Zealand fitted naturally. This fear was arguably stimulated by the stasis in APEC (which accounts for a very large proportion of New Zealand’s trade) and ‘the failure of world leaders to agree on an agenda for a new wave of trade liberalization’ (Far Eastern Economic Review, August 17th 2000). Box 8.5 Insurance Policies Signing an RIA may offer assured access to partner markets in two senses: first, avoidance of day-to-day harassment from anti-dumping or countervailing duties and other administrative means of protection, and, second, a haven if total trade war breaks out. Mercifully, the latter is a very low probability event at present and it is plainly very difficult to forecast what form it would take. However, to get a feel for the orders of magnitude at stake consider some recent results from Whalley (1998). Whalley uses a CGE model of the world economy disaggregated into seven countries or regions; six potentially fight trade wars and the other (the rest of the world) remains completely passive. Trade wars have different outcomes according to which countries or regions have combined to form CUs. Using actual 1986 values as a base, Whalley explores trade wars in which each country or bloc fixes its tariffs to maximize its own welfare taking rivals’ tariffs as given. (Of course, this ignores WTO structures on raising tariffs, but the insurance is intended for just such a break-down). The only constraint is that if an RIA exists before war breaks out it remains in operation afterwards. The table below considers the implications of four possible configurations of customs unions measured relative to 1986 actual values. The precise numerical results should not be taken seriously, for they are subject to a host of uncertainties, but the broad pattern is informative. In trade wars large economies suffer least, or even gain (Column 1, USA, EC); others suffer heavily especially if they are highly dependent on a large bloc that becomes very restrictive (as Canada and “Other Western Europe” are). Entering the bloc basically solves the problem: compare Canada in columns (1) and (2), Mexico in (2) and (3), and Other Western Europe in (3) and (4). As one small country protects itself, the burdens on others increase – see Japan and the rest of the world. With losses of this size, the incentives to seek accession if the danger of trade war increases are huge. Other Western Europe has a turnaround of 43.6% of GDP from joining an American-European CU. Even a small-perceived increase in the probability of 212 trade war would be sufficient to persuade it to bear the trade diversion and other costs of entry to avoid this. The table below refers to CUs: hence the blocs coordinate their external trade policies and can exploit, in so small a model, a great deal of market power to raise their tariffs. If the RIAs were FTAs, the costs of being excluded would be rather lower and would not rise monotonically as the FTA expanded (because a large FTA tends to reduce its external tariffs to reduce the costs of trade diversion). The basic idea that being outside is very costly persists, however. LOSSES OF ECONOMIC WELFARE AS % OF GDP RELATIVE TO 1986 (Equivalent Variations) Trade War With: No CUs Canada-US CU North America CU North America- Europe CU US 1.2 0.5 -0.4 0.5 Canada -25.5 0.9 0.4 -0.7 Mexico -8.5 -8.5 0.1 -0.3 Japan -5.2 -5.2 -5.2 -5.4 EC (12) 3.7 3.4 3.4 2.5 Other Western Europe -32.2 -33.1 -33.5 10.1 The rest of the world -10.6 -10.9 -11.1 -13.4 World Total -6.0 -5.8 -5.8 -6.2 Source: Whalley (1998) 8.3.5 RIAs and Trade Negotiations If RIAs made trade negotiations easier, perhaps they would help the world evolve toward freer trade. Coordinated coalitions may have greater negotiating power than their members individually (Section 8.3.2) and such coalitions may facilitate progress just by reducing the number of players represented in a negotiation (Krugman 1993, Kahler 1995). But this result is not guaranteed. For example, a negotiation comprising one dominant partner and a competitive fringe of small countries might be easier and proceed further than if the fringe coalesced into a significant counterforce. However, if the blocs are genuinely unified it is probably reasonable to expect negotiations to be easier with fewer partners. Unfortunately, however, this condition is rarely met, so that any gains from having fewer players in the last stage of a negotiation are offset by the complexity of agreeing joint positions in the first phase. This tradeoff is examined in Andriamananjara and Schiff (2001). The difficulties of achieving a European position on agriculture and cultural protection in the Uruguay Round are well known, and formulating EEC positions in the Tokyo Round proved complex (Winham 1986). Moreover, two-stage negotiations 213 need not be more liberal than one-stage ones (Basevi, Delbono and Mariott 1994). To be sure, Germany and the United Kingdom pressured France to agree to the agricultural deal in the Uruguay Round, but they had to make potentially trade-restricting concessions on “commercial defense instruments” (anti-dumping) to clinch the deal. The negotiating power of African countries would not be greatly enhanced by cooperation, and the benefits are not likely to outweigh the costs of combining their different interests into a single negotiating position (Wang and Winters, 1998). The CUs that attend the next round of global trade talks will need to establish procedures for determining their negotiating positions. SACU’s previous practice of delegating all responsibility to South Africa begins to look less tenable as divisions emerge between members, and Mercosur has yet to devise really robust internal decision- making capacity. Thus, at least into the foreseeable future, RIAs do not seem likely to facilitate even a traditional trade negotiation. Moreover, if RIAs are being extended or new ones created, they can completely swamp developing countries’ limited negotiating capacity (Box 8.6). Moreover, as WTO has extended its reach, it has embraced subjects in which most central CU authorities have no mandate to negotiate. Mixing national and CU responsibilities seems unlikely to simplify matters, and it is not realistic to expect member countries to surrender sovereignty on sensitive issues to regional bodies just because trade negotiations are in train. Box 8.6 The Overburdened Negotiator Reserves of administrative skill, political capital or imagination are finite; if they are devoted to an RIA they are not available for multilateral objectives. These arguments were advanced – somewhat implausibly – to explain both EU and US behavior during the Uruguay Round, but they must be several times more important for developing countries. Negotiating an RIA, especially with a major power that has its own objectives, will absorb a huge proportion of the scarce policy-making skills of a developing country. Such skills are typically so scarce that many developing countries have the same negotiator dealing both with the EC in Brussels and the WTO in Geneva. In fact, the governments of a number of smaller European countries have asked the WTO to postpone its Trade Policy Reviews exercises on their countries because they are wholly absorbed in negotiating Association Agreements with the EU. Moreover, flying to Brussels or Washington to undertake regional negotiations is altogether more gratifying than working quietly at home to reduce arbitrary tariff peaks, or improve customs administration. This, of course, is part of the reason why policy makers and private-sector groups are prepared to grasp the painful nettles of reform that RIA negotiations call for and to stick to the agreements they make. However, it also shows that the process can be harmful if the RIA does not deliver benefits commensurate with the opportunity costs of negotiation. The importance of developing country capacity constraints is illustrated in the recent discussion of multilateral trade policy, where the lack of capacity has become a prominent theme. For example, the WTO’s Doha Ministerial Declaration has 19 mentions 216 members themselves, but none of the definitions that have been proposed absolutely guarantees such benefits. Srinivasan (1998) has called “open regionalism” an oxymoron – and that is surely true at the limit of its range: a perfectly open economy could not discriminate in the way that regionalism in the trade sense requires. However, once we come in from the edge, it does make sense to ask whether some RIAs are more open than others. Writing on APEC, the group for which the term was coined, Bergsten (1997) offers five definitions of “open regionalism”: (a) “Open Access” whereby any country willing to abide by its rules may join an RIA. Bergsten argues that, strictly interpreted, this is not realistic, because RIAs have restricted geographical domains, but easy access to countries within their domains would be one acceptable definition. Bergsten defines the EEC as open in this respect. (b) Unconditional MFN (or Concerted Unilateralism): this was the definition of the early APEC advocates, who saw the coalition as a means of encouraging countries to liberalize together and so provide for each other some of the terms of trade and political economy benefits of a full GATT round. While some members of APEC still adhere to this aspiration, Bergsten is doubtless correct in saying that it is quite unacceptable in the US, where reciprocity is seen as a essential part of liberalization.18 It would, of course, also not be regionalism in the terms of this report. (c) Conditional MFN would extend intra-APEC liberalization to any country that reciprocated. Given APEC’s size no country would be likely to reject the offer of an FTA, Bergsten says, but it might take time for others to come on board, during which there would be trade discrimination. There might also be resentment at APEC making take-it-or-leave-it offers. Of course, this is very similar to “open access” but requires an operational definition of “reciprocity.” Bergsten would threaten conditional MFN – indeed says APEC has already implicitly done so – as a means of obtaining (nearly) global deals such as the ITA, which started with APEC in 1996. (d) Global Liberalization through traditional unilateral and multilateral trade liberalization on an MFN basis. It is possible that APEC could lead a movement to remove all trade barriers, by its own internal free trade deadline of 2010 for developed and 2020 for developing countries. (e) Trade Facilitation: is APEC countries reducing border frictions and pursuing policy integration, but with a focus on elements that operate multilaterally. APEC has yet really to decide between these alternatives, as there has not yet been any “APEC liberalization.” Members have certainly not yet introduced any discriminatory trade policies (with the minor exception of the APEC business visa), but neither have they yet moved beyond implementing their Uruguay obligations and, for developing members, their own unilateral reforms. 18 It now seems likely that Japan would be unwilling to pursue unilateral approaches - Scolley and Gilbert (2001). 217 For the future, Bergsten recommends a combination of (b) through (e) above, to make clear that APEC’s objective is global liberalization, that it will achieve internal liberalization by 2020, that it – or at least its larger members – will discriminate in a WTO-consistent fashion if other countries do not reciprocate, and that it welcomes other countries proposing sectors and timetables for liberalization – i.e., that APEC would negotiate, rather then dictate terms, for its extension to the rest of the world. Although perhaps more positive in its approach and timetable, this manifesto is not very different from the EEC’s 1957 statement that “by establishing a customs union between themselves, member states aim to contribute, in the common interest, to the harmonious development of world trade, the progressive abolition of restrictions on international trade and the lowering of customs barriers.” (Article 110 §1, Treaty of Rome). Other commentators have taken up the cry of “open regionalism.” Echavarria (1998) sees “open regionalism” in the Andean Pact on the grounds that it lowered tariffs relative to the 1980s and Brazilian Foreign Minister Luiz Felipe Lampreia proclaimed “open regionalism” in Mercosur on the same grounds and those of its enlargement (to the UN General Assembly in September 1996). The CEA (1995) defined US policy as laying the foundation for “open, overlapping plurilateral trade agreements as stepping stones to global free trade,” while Pelkmans and Brenton (1997) see recent EU policy as “open regionalism” in the sense of “GATT compatibility” and as having gone “some way” toward “open regionalism” in the non-preferential sense! Past WTO Director General Renato Ruggiero declared “The answer [to marrying regionalism and multilateralism] is ... ‘open regionalism’,” which he then defined as “in practice...the MFN principle” (quoted in Srinivasan 1998). Openness is an important component of development and a valid objective for all developing countries; if countries feel they must have regionalism, let it be genuinely open. But “open regionalism” is a slogan rather than an analytical term. It is defined in so many different ways that it conveys no information about an RIA other than that its members are embarrassed to be thought of as protectionist. In particular, a claim of “open regionalism” should confer on a bloc no presumption of economic value and no immunity from analysis to see if it is acting in either its own or in other countries’ interests. 8.4 Regionalism and the WTO The previous analysis suggests that international policy toward regionalism should aim to: • Encourage RIAs to achieve trade creation and avoid trade diversion, both for the sake of members and to minimize harm to excluded countries; • Permit deep integration, including nation building, between members; • Preserve the effects of previous liberalizations and provide credibility for any liberalizations that form part of the RIA; and 218 • Support a liberalizing dynamic within member countries and in the world trading system as a whole. 8.4.1 GATT, and all that. The instrument we have for international policy on trade blocs is the WTO, and this section explores how it manages regionalism and whether its rules could be reformed to help it do better.19 RIAs are an officially sanctioned – but conditional – exception to the GATT’s rules on non-discrimination. The conditions imposed on RIA formation doubtless constrain and mold the pattern of regionalism in the world, but they are neither adequate nor adequately enforced to ensure that regionalism is economically beneficial for either its members or excluded countries. However, although improved adherence to current rules is desirable, no feasible reform can guarantee that only beneficial RIAs are created. The responsibility for good outcomes falls on governments themselves; outside a complete ban, they cannot tie their own or each other’s hands sufficiently tightly in the WTO to preclude the possibilities of signing harmful RIAs. The world trade system works pragmatically and consensually. The GATT was created in 1947 as a temporary body to assist countries in trade liberalization. Its role was to codify and record a series of tariff reductions that its members wished to make, and to provide a structure to give credibility to those reductions. It discouraged the reversal or nullification of tariff cuts by restricting the use of policies that impose duties on trade on an ad hoc basis, such as anti-dumping duties and emergency protection, and equivalent policies, such as internal taxes on imports. It also defined important mechanics of trade, such as the valuation of trade for customs purposes. A key concept of the GATT, indeed the cornerstone of the present world trading system, is non-discrimination between different sources of the same imported good, which is achieved by requiring members to give each other most favored nation (MFN) treatment, except in specified circumstances. With an assurance of non-discrimination, when A negotiates a reduction in one of B’s tariffs, it knows that the commercial value of its effort will not be undermined by B then offering C an even lower tariff. This, in turn, makes A more willing to “buy” the concession by reducing one of its own tariffs on B, and so encourages trade liberalization. Over 50 years of operation the GATT continued in a low-key, consensual, member-driven, fashion. It did not “adjudicate” trade disputes, but had a dispute settlement process, less concerned with law than with solving disputes in a way that preserved the previously negotiated balance of benefits, maintained consensus and 19 The rules of international commerce are embodied in three main agreements: The General Agreement on Tariffs and Trade (GATT), The General Agreement on Trade in Services (GATS) and the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs). They are administered by the World Trade Organization (WTO), two of whose major tools are the Trade Policy Review Mechanism (TPRM) and the Understanding on Dispute Settlement. The WTO has 145 members; the major non-member economies, which are seeking accession, are Russia, Ukraine and Saudi Arabia; the other major group of current candidates are the countries of Eastern Europe and Central Asia. ## 221 would not preclude harmful RIAs: even wholly GATT-compatible RIAs can be predominantly trade diverting, excluded countries can suffer terms of trade declines, protection can increase and institutions can arise that make liberal policies less likely. Moreover, there are major difficulties in interpreting the WTO conditions on regionalism. Even following the Uruguay Round Understanding there is no agreement about what “substantially all trade” means – nor even whether it refers to the proportion of actual trade covered or the inclusion of all major sectors of the economy. Similarly the treatment of non-tariff barriers in assessing the overall level of trade restriction is not defined, nor is that of rules of origin. The requirement that “other restrictive regulations of commerce” be removed between members is ambiguously worded: several exceptions to this requirement are identified explicitly but other barriers, including anti-dumping duties and emergency protection, are not. Complete integration between members of an RIA would abolish all of these barriers and so their continuation – as for example in NAFTA or the Euro-Med agreements – suggests an unwillingness to proceed too far in that direction. Perhaps because of its ambiguities, Article XXIV has been notoriously weakly enforced. RIAs have to be notified to the GATT and until 1996, each was then reviewed by an ad hoc working party to see if it was in conformity with the Article. WTO (1995, p. 16) reports that of 69 working parties reporting up to and including 1994, only 6 were able to agree that an RIA met the requirements of Article XXIV, of which only two – CARICOM and Czech-Slovak CU – remain operative. However, the remainder did not conclude that agreements were not in conformity; they merely left the matter undetermined. This agnosticism is essentially the product of the GATT’s consensual nature. The first major test of Article XXIV was the Treaty of Rome establishing the EEC. The political pressure to permit it was enormous: EEC countries would almost certainly have put the EEC before the GATT in the event of conflict and the US strongly supported the treaty. The treaty, however, clearly violated Article XXIV, and so the only feasible solution was not to push the review to conclusion.22 Given a start like this, the EEC’s willingness to support more or less any RIA in the GATT, the need for working parties to reach consensus, and the GATT’s inability to make an adverse determination without the acquiescence of the party at fault, it is hardly surprising that future reviews proved little more demanding.23 Nor have matters improved with the establishment of a single Committee on Regional Trading Agreements to conduct the reviews. The inability to rule on conformity does not mean that the rules have had no effect, for we do not know the extent to which they have influenced the structure of RIAs that have come forward, nor 22 For example, in reviewing the treaty, the head of the GATT secretariat expressed ‘the view, with which he thought there was no disagreement, that the incidence of the common tariff was higher than that of the rates actually applied by the member states at the time of entry into force of the Treaty of Rome’ (GATT Document C/M/8 p.6; cited in GATT, 1994, p. 750). 23 Under GATT procedure, finding a party in violation of its obligations required unanimity, i.e. including the violating party. This is not true of WTO. 222 which potential arrangements they have discouraged.24 It is not an encouraging record, however, either from the point of view of enforcing current rules or from that of rewriting the rules to increase their ability to distinguish good from bad RIAs. Finally, Articles XXIV.10 and XXV of the GATT can be used to grant waivers to make otherwise inadmissible policies GATT-legal. This was done for the European Coal and Steel Community (1952) and the US-Canada Auto Pact (1965). Under WTO, waivers are still feasible but are time limited. 8.4.3 The rules are much weaker for developing countries As if all this were not enough, a further complication for developing countries is the “Enabling Clause25”, which significantly relaxes the conditions for creating RIAs that include only developing countries. It drops the conditions on the coverage of trade, and allows developing countries to reduce tariffs on mutual trade in any way they wish, and non-tariff measures “in accordance with criteria which may be prescribed by the” GATT members. It then supplements the first condition with the non-operational requirement that the RIA not constitute a barrier to MFN tariff reductions or cause “undue difficulties” for other contracting parties. In practice, developing countries have had virtual carte blanche. Twelve preferential arrangements have been notified under the Enabling Clause, including LAIA, ASEAN and the GCC. Internal preferences of 25% and 50% figured in ASEAN’s trading plans and also in many of the arrangements concluded under the LAIA and in the GCC. There is little sign that internal preferences have undermined MFN agreements with other trading partners, but then, until recently, these countries did not make many MFN agreements. Indeed, until the late 1980s, the Latin American and African countries’ frequent use of regional arrangements and weak participation in the multilateral rounds might suggest a substitution of one form of liberalization for the other. More worrying were the sectoral agreements that abounded in Latin America. Nogues and Quintanilla (1993) argue that there is little doubt that the 17 agreements that Argentina and Brazil had signed by 1986 generated significant trade diversion. The Enabling Clause further dilutes the weak discipline that Article XXIV imposes. Even if Article XXIV does not actually stop many harmful practices, it does at least avoid automatically giving them the respectability of legal cover. Thus, while the GATT knowingly and willingly permitted LAFTA (1960) and the initial notification of ASEAN (1977) to violate Article XXIV (Finger, 1993b), at least it required continuing 24 Within the GATT there was a feeling that the article had influenced the structure of US-Canadian and US-Israeli agreements (private communication from senior staff member). We can also identify cases where WTO rules, or their equivalent, have prevented RIAs. For example, in 1932 Britain and the US refused to waive their MFN rights, preventing the implementation of the Ouchy Convention, a forerunner of Benelux, Viner (1950). Similarly, negotiators of the draft Multilateral Agreement on Investment found no way of preventing some concessions on services among members from also applying to non-members via the GATS MFN clause. Hence, they held back such concessions. GATS Article V permits regional arrangements, but the MAI was far too narrowly defined to qualify as one. 25 “The Decision on Differential and More Favorable Treatment, Reciprocity and Fuller Participation of Developing Countries” (1979). 223 consultation with partners and left open the possibility of challenge in the dispute settlement process. The Enabling Clause offers more cover in various areas, and thus erodes even this discipline.26 8.4.4 New rules for services repeat the same problems Article XXIV and the Enabling Clause of the GATT refer to trade in goods. The equivalent for services in Article V of the GATS, which is modeled closely on them. The requirement not to raise barriers to third countries is rather tighter: it is applied sector by sector rather than “on the whole,” and third country suppliers already engaged in “substantive business” in an RIA territory before the RIA is concluded must receive RIA treatment. The “substantially all trade” ambiguity is only slightly abated, with an explicit note that “substantially” be “understood in terms of number of sectors, volume of trade, and modes of supply.” For covered sectors “substantially all discrimination” is to be removed, but as this is defined as comprising elimination of barriers and/or prohibition on new or more discriminatory barriers, it need amount to very little.27 Developing countries receive “flexibility” on “substantially all discrimination” and exemption from the need to give RIA treatment to third country firms with “substantial business” in member countries. 8.4.5 ‘Feasible’ and ‘desirable’ don’t overlap The WTO rules on RIAs are not exactly broken, but they are creaky, and it is worth asking what might be done about them. We focus here on their economic content – as defined in the introduction to this section – and on the feasibility of reform. We also require that any reforms be clear and operational, removing ambiguity rather than adding to it. Feasibility depends on the attitudes of member countries and the need to remain within the GATT’s basic pragmatic and consensual framework. Feasibility seems to us a more binding constraint than devising economically sensible rules.28 Few countries within RIAs appear to seek tighter discipline, and as the EU continues its Mediterranean agreements and looks to implement the Cotonou Agreement and as the US contemplates the FTAA, major political backing for tightening looks improbable. Neither the EU nor the USA submitted proposals to the 1999 Seattle Ministerial Meeting of WTO. (WTO document JOB (99)/4797/Rev.2). An RIA that does not reduce external barriers almost inevitably causes trade diversion. One counter to this would be to require RIA members to liberalize, both to reduce diversion and to induce external trade creation with non-members. Finger (1993) views these reductions as a “price” to be negotiated to persuade non-members to forego their MFN rights. How far the parties are prepared to go in a negotiation, however, is determined by the prevailing rules and enforcement mechanisms, which define the 26 There is also an unresolved dispute about whether Article XXIV can be applied to an arrangement notified under the Enabling Clause, as the US demands for Mercosur. 27 Together these requirements seem to impose no discipline on the sectors that are excluded from the RIA, although they may still be covered by the members’ GATS obligations. 28 Schott (1989) offered an early analysis of these sorts of points. ## 226 Unfortunately the CRTA has still not got into its stride after six years. Its assessments of particular cases have been stymied by the lack of clear systemic rules and its discussion of rules stalemated on exactly the same “substantially all” and “other regulations” issues as bedevilled the Uruguay Round discussions. By December 2000 the Committee had initiated consideration of 86 RIAs (including 32 inherited from previous working parties). It had completed factual analysis of 62 of these, but had been unable ‘to conclude any examination referred to it’ (Report by Chairman of CRTA to the WTO General Council December 2000). The CRTA is the key to improved near-term management of RIAs by the WTO. Although RIAs are open to dispute if third countries feel aggrieved (at least until the CRTA has formally certified their WTO-conformity), the rules seeking “serious” intent to integrate are not really vulnerable to this process. Third countries are unlikely to press RIAs to include more sectors when they expect this to increase trade diversion. Similarly, why would a third country seek to free RIA members from the threat of each others anti- dumping legislation? Members do not normally bring internal disputes to the WTO.29 Hence if issues concerning the coverage of sectors or the depth of integration are missed at the outset they are missed forever. Recently an RIA has figured in the WTO’s Dispute Settlement procedure. As part of the EU-Turkey Customs Union, Turkey imposed quotas on imports of certain textiles and clothing, in order that the EU’s quotas (under the Multi-Fibre Arrangement) should not be undermined by deflected trade. India complained and won a ruling against the quotas on the grounds that the quotas were not fundamental to the customs union. Rather, the Dispute Panel said, alternative means should be found to meet Turkey’s objectives such as using tariffs (for which India could demand compensation), phasing out the EU restrictions, or rules of origin to control the movement of third country goods from Turkey to the EU. This ruling suggests a willingness to subordinate Article XXIV to other parts of the GATT, which could have significant implications for new CUs or expansions. The WTO’s rules on regionalism are far from perfect, but it is impossible to devise rules that reliably sort beneficial from harmful RIAs. If that process is to be done at all, it would have to be done case-by-case by the CRTA. But the CRTA faces a serious timing problem. Unless agreements are submitted to the WTO early in the process of negotiation – in which case they will be very provisional – reviews will generally be too late to influence their initial form. Otherwise, reviews will be too late to affect public debate and will, if they call for changes, upset carefully negotiated compromises. For that reason they will be resisted and resented by members, which is bad news for a consensual organization. Thus considerable political courage will be called for to enforce CRTA findings, until their requirements are sufficiently understood and respected by members to be met ab initio. This process of review and response would be aided by detailed economic studies of RIAs stretching well beyond the legalities of Articles XXIV and V. 29 The USA and its partners still use the WTO dispute settlement, but there has never been a formal GATT dispute between the EU and any country with which it has a formal RIA. 227 Both immediately and ultimately the responsibility for good RIAs lies with governments themselves. 8.4.7 Conclusion: Rules are not the answer Rules are not the answer, nor even a large part of the answer, for ensuring that regionalism is beneficial. The need is for understanding, for in the end, subject only to imperfect constraints on the effects on excluded countries, governments will act in what they believe to be their best interests. Rules can help to define this, mainly by informing parties to the debate about perceived norms, but on topics that are as case specific and sui generis as RIAs, advocates will always be able to final plausible exceptions to norms. No set of rules seems likely to be very effective at distinguishing beneficial from harmful RIAs. Thus it seems unlikely that great effort to rewrite the WTO’s rules on RIAs will be adequately rewarded. None of the fundamental reforms to Article XXIV and V proposed to date seems likely to command enough political support to make any progress. None of the minor ones seems worth the effort. Thus our recommendations are: • extend the disciplines of Articles XXIV and V to RIAs between developing countries, • enforce these disciplines rigorously in the CRTA, especially those on coverage and depth of liberalization, and • use the dispute settlement procedure to enforce the rights of third countries not to face increases in protection either directly or indirectly through the use of tools such as rules of origin. Even these steps will require major expenditure of political capital by many countries. We also, therefore, suggest continuing studies of particular RIAs, not just in terms of Articles XXIV and V disciplines, but also in terms of their overall effects on economic performance. This will help policy makers and the public understand what they may and may not expect from regional integration. 228 Appendix I: WTO Provisions on Regional Integration Arrangements (Extracts) Article XXIV of the GATT 4. The contracting parties…also recognize that the purpose of a customs union or of a free trade area should be to facilitate trade between the constituent territories and not to raise barriers to trade. 5.(a) With respect to a customs union…the duties and other regulations of commerce imposed at the institution…shall not on the whole be higher or more restrictive than the general incidence of the duties and regulations of commerce applicable in the constituent territories prior to the formation of such union… (b) With respect to a free-trade area…the duties and other regulations of commerce maintained in each of the constituent territories and applicable at the formation of such free-trade area...shall not be higher or more restrictive than the corresponding duties and other regulations of commerce existing in the same constituent territories prior to the formation of the free-trade area… (c) Any interim agreement…shall include a plan and schedule for the formation of such a customs union or of such a free-trade area within a reasonable length of time. 7.(a) Any contracting party deciding to enter into a customs union or a free-trade area, shall promptly notify the CONTRACTING PARTIES and shall make available to them such information… 8.(a) A customs union shall be understood to mean the substitution of a single customs territory for two or more customs territories, so that: (i) duties and other restrictive regulations of commerce (except, where necessary, those permitted under Article XI, XII, XIII, XIV, XV and XX) are eliminated with respect to…substantially all the trade in products originating in such territories… 8.(b) A free trade area shall be understood to mean a group of two or more customs territories in which the duties and other restrictive regulations of commerce (except, where necessary, those permitted under Articles XI, XII, XIII, XIV, XV and XX) are eliminated on substantially all the trade between the constituent territories in products originating in such territories. 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